Lula’s Surprising Performance in Brazil

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Despite initial doubts, Lula is exceeding expectations since reassuming the presidency on Jan. 1. The iShares MSCI Brazil exchange-traded fund (ticker: EWZ) has surged by 25%, while the real has strengthened by 14% against the dollar. In addition, local-currency bond yields have dropped significantly, by 250 basis points.

While some of this success can be attributed to favorable circumstances, such as a bountiful harvest for Brazilian farmers compared to the drought suffered by export competitor Argentina, the 77-year-old leader has also demonstrated his seasoned political acumen.

One of Lula’s notable achievements is the implementation of a “fiscal framework” to replace Brazil’s defunct spending cap. This framework sets limits on government spending in relation to revenue growth, with the goal of ensuring primary budget surpluses (excluding interest payments).

In a remarkable move last month, Lula successfully maneuvered a long-awaited reform through Congress: the rationalization of the country’s value-added tax. This reform had eluded Brazilian presidents for decades. As a result, ratings firm Fitch upgraded Brazil’s sovereign credit rating from BB- to BB.

Thierry Larose, portfolio manager for emerging markets local debt at Vontobel Asset Management, comments, “Everyone who was afraid of Lula was very wrong and surprised.”

The positive trajectory may continue for some time. Brazil’s central bank, which had raised interest rates to 13.75% to combat post-pandemic inflation, has recently begun cutting rates. On Aug. 2, they reduced rates by 50 basis points to 13.25%.

This reduction in interest rates will likely benefit consumer stocks like Localiza Rent a Car (LZRFY) and debt-fueled tech innovators like Nu Holdings (NU), the parent company of fintech Nubank, according to Malcolm Dorson, head of emerging markets strategy at GlobalX exchange-traded funds.

Despite the recent market rally, equity valuations remain attractive, trading at eight times earnings compared to a historical average of 9.75, Dorson adds. The promising outlook further solidifies Lula’s impressive performance in Brazil’s political and economic landscape.

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The Return of Affluent Brazilians

Affluent Brazilians, who previously withdrew their money from the markets due to fears surrounding Lula’s policies, are gradually making a comeback, according to Edwin Gutierrez, head of emerging market sovereign debt at asset manager abrdn. “A lot of locals had a strong dislike for Lula,” he says. “They may have overreacted.”

Optimistic Outlook for Bond Markets

Rodolfo Luzio, head of emerging markets research at MFS Investment Management, reveals that bond markets are predicting a decrease of 350 basis points in central bank rates, potentially bringing them down to around 10%. However, he believes they could go even lower to a “neutral rate” of 7.5% or 8%. Luzio states, “We hold a positive view on rates in Brazil. The bonds offer significant value.”

Challenges Persist

Nonetheless, Brazil still presents challenges that cannot be overlooked. With debt servicing already occupying a quarter of the budget, the country cannot afford to take on much more. Lula’s fiscal framework may slow down the accumulation of debt, but it is unlikely to reverse the trend.

“Our upgrade does not indicate complete confidence in the framework,” explains Todd Martinez, overseeing Fitch’s Latin American sovereign ratings. “Debt will continue to rise, albeit at a slower pace than our previous projections.”

Concerns Surrounding Central Bank Takeover

A more immediate concern is Lula’s increasing influence over the central bank, which he has criticized for its hawkish stance. “I don’t know who he’s serving, but it’s certainly not Brazil,” the president recently remarked regarding bank governor Roberto Campos Neto.

Brazilian presidents appoint two central bank governors each year from a pool of nine candidates. It is highly likely that Lula’s appointee, Gabriel Galipolo, will succeed Campos Neto at the end of 2024, a prospect that investors are not enthusiastic about. “Lula will appoint his protégé, who will aggressively lower interest rates,” predicts Arthur Budaghyan, chief emerging markets strategist at BCA Research. “They intend to tackle debt through inflation.”

Cautious Optimism

“We maintain a slightly overweight position on Brazil,” states Dorson from GlobalX. “However, even during prosperous periods, the country tends to experience significant volatility.”

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